I recently spoke with Ryan Sheftel who runs fixed income electronic market making for Credit Suisse. CS is taking its experience from building AES in the equities market to fixed income, leading to some pretty cool trading tools.
When automated market-making meets an already liquid market backed by real money trades, arbitrage opportunities quickly follow, which is the direction most liquid portions of the swaps market are moving. Even in this pre-regulation implementation time that continues to linger, adoption of electronic trading is finally starting to gain momentum. Data from Bloomberg, CreditEx and Tradeweb in just the past months show a sharp increase of on-screen execution and despite continued lobbying relating to specific details of each regulatory proposal, the market, by and large, has accepted that the swaps market is going to move to into the electronic age … finally.
For some trading desks, this means spreads will tighten and profits (in the near term) will decline. It is true that spreads in liquid markets such as 10-year interest-rate swaps and index CDS are already tight and some people argue that because of this, there isn’t much profit at risk if spreads tighten further. But if you consider a quarter basis point decline from one-half basis point to one-quarter basis point, that equals billions of dollars in a market that measures its yearly gross turnover in quadrillions.
Fortunately, there’s no reason to fret because both existing and new swaps dealers will continue to make plenty of money. The old adage that it takes money to make money is undoubtedly true here. Changes necessary comply and compete will be costly; a business model that has stood still for nearly 20 years must be recreated and an infrastructure that was designed for weekend batch jobs must be transformed into one that can handle real-time clearing and intraday margin calculations. But once all is said and done, the new opportunities are enormous as a whole world exists, full of untapped trading potential.
The most exciting opportunities exist for firms that are already playing a part in trading the futures and cash fixed income markets electronically. Swaps dealers, principal trading groups and some hedge funds fit the bill. Arbitrage opportunities between swaps, bonds, futures and even FX will quickly emerge as electronic access allows development of automated strategies that before were never possible.
US government debt products are some of the most liquid in the world. Products such as Eurodollar futures and US Treasury futures are both heavily traded and have valuations that are highly correlated to US government debt. Basis trading between these products exists today. Add in interest rate swaps, which can be synthesized using futures and are closely aligned with US debt, and the arbitrage opportunities become clear. Correlations between interest rate and credit products, which throw credit default swaps (CDS) and corporate bonds into the mix, are also compelling trading propositions.
The primary focus will be on relative value trades, i.e., looking for theoretical price difference between two similar structures. For example, a strip of Eurodollar futures could be traded simultaneously with a 5-year interest rate swap when the price of the former isn’t in line with the price of the latter, taking into account convexity bias and differences between swaps and futures.
Statistical arbitrage will exist in the new swaps market but will be slower to develop because historical data that is detailed enough to help determine trading signals and develop automated trading strategies is nearly non-existent. Not until trading, clearing and reporting mandates are all in place will sufficient market and trade data be generated and publically available to make statistical arbitrage trading accessible to most trading firms.
Ironically, creating the trading strategies is seen as the easy part. Several TABB Group conversations with automated trading firms have confirmed that creating algorithms to automatically trade swaps is not much of a stretch. The proposed strategies are not much different than those used for related exchanged-traded products today, and so adopting those algorithms to work in the new swaps market is manageable work. However, creating an infrastructure to gather, consume and disseminate the required data is not an easy task.
Swap execution facilities (SEFs) are also set to gain from these changes, operating as some hybrid of exchange and agency broker, making money not on the direction of the market but on the total volume they process, and automated trading is good for volumes. An upcoming TABB Group study for which two dozen swaps dealers were interviewed shows further potential for SEFs that offer trading in other products. Nearly 80% of swaps dealers believed that those SEFs with an already liquid cash market, whether in US Treasuries or corporate bonds, would have an advantage in gaining swaps liquidity. The ability to execute the aforementioned relative value trades on a single platform is apparently appealing.
Whoever ultimately wins or loses, more automated, relative-value trading can only improve pricing amongst these related fixed-income instruments, leaving the market more efficient for end users and real money accounts. Top-tier dealers will not have smaller trading desks, but desks with a few more computer scientists and a few less MBAs.
We’ve been down this road before.
But this time we can build the new market structure with the benefit of hindsight.
Defining a “block trade” in the swaps market is one of the many jobs of the regulators in the next few months. As this story points out, average trade sizes for swaps change drastically based on product and market conditions making it pretty difficult to set a single number. Maybe more important is the reporting delay allowed for block trades giving dealers a little more flexibility in what they show the world and when:
The block trade reporting exemption could provide some welcome flexibility for dealers, according to Kevin McPartland, senior research analyst at TABB Group. It “creates an environment where trades can still be executed bilaterally as long as they are ultimately reported to a SEF and the SEF reports that trade to the regulators after the decided time delay,” he wrote in a soon-to-be-published research note.
The Flash Crash may very well be talked about more these days than the credit crisis. Not only is it an area of interest for regulators and traders but technologists as well. IET takes a look at the issue from a technology perspective in this article.
‘It seems to be more of a market structure issue,’ says Tabb Group’s Kevin McPartland. He points out that the collapse was fast, but the recovery from the situation where valuable shares were offered for a penny each came equally quickly.
‘Did it happen quickly because of the technology? Of course. But the rebound was also fast. Algorithms were able to spot what was going on, and to see a buying opportunity. In previous years, [in a situation like 6 May] the markets would have had to close for the rest of the day.’
This is the first announced equity swap focused SEF I’ve come across. The people at the help of this company come from Goldman Sachs electronic trading and have an interesting approach that is worth keeping an eye on. I’m sure there will be many more SEF announcements to come in the the next few months, but there’s a lot of opportunity to go around.
Kevin McPartland, a senior analyst at TABB Group who has been following the development of SEFs closely, said this team has found a niche not yet cornered by any other potential competitor. He did note, however, that their focus on the sellside may change as the market landscape changes with coming regulation. “What constitutes a dealer in the new world?” he asked. “That really changes the game.”
I created this video while I was in Hong Kong last week for Trading Architecture Asia. The audio isn’t that great unfortunately, so we’ve transcribed the commentary which you see below (its also on TabbFORUM).
…and the transcription:
This week I’m in Hong Kong for Trading Architecture Asia 2010.
If it’s a sign, almost every session in the morning has been standing room only, so there’s certainly a big focus from exchanges, buyside firms, sellside firms and technology providers all across Asia on low latency trading and low latency infrastructure.
One of the main focuses has been on the Singapore exchange. They’re building out a tremendous new co-lo facility and co-lo offering. They’re also in the midst of creating a matching engine that’s supposed to be one of the fastest in the world – down to 90 microseconds – to match an order. That rivals most of the exchanges in the U.S. and Europe.
Japan also continues to be a focus area in terms of low latency trading. The Tokyo Stock Exchange’s new Arrowhead trading platform has tightened spreads and driven up volumes – and has been quite successful. One interesting point: before Arrowhead, it would take 300 milliseconds to execute an order at the Tokyo stock exchange. If you were a trader in Tokyo, it was actually faster to send your orders over to New York through fiber optics and execute at a New York exchange than it was to execute locally in Tokyo because the matching engine was so slow. So clearly this development, this new matching engine at the TSE will help them considerably.
There’s also a lot of fragmentation talk going on in Tokyo and in Asia as a whole. Chi-X, among others is looking to create not only new liquidity pools in Tokyo but pan-Asian liquidity pools. So we’ll have to see. That’s early stages but certainly causing the incumbent exchanges to pay attention and increase their strategies.
Lastly there’s been quite a bit of discussion around the markets in India. Cleary this is a big, big economy with huge potential. Both the Bombay Stock Exchange and the National Stock Exchange of India were here at the conference talking about their offerings and their approaches.
The National Stock Exchange of India is the market leader right now but the BSE is coming up close and trying to take market share back from them. There was just an announcement from the regulators in India that smart order routing is allowed and now acceptable, so that’s a huge step forward. Algo trading will grow and both the NSE and BSE will allow colocation as well, so there’s considerable competition there.
One thing that I found interesting, one of the other rules that was just passed India is now retail investors are allowed to trade over mobile phones. So on one hand we have colocation and ultrafast trading by institutional traders in India and on the other hand we’ve got retail investors in remote villages trading on mobile handsets. They also mentioned there’s quite a bit of trading that goes on via satellite. Satellite is at the opposite end of the latency spectrum where we’re talking somewhere between 800 and 900 milliseconds to execute an order via satellite.
The week in Hong Kong has been quite eye opening. Clearly there’s a lot of opportunity here. The East has been able to learn from the process that’s gone on over the past decade both in the U.S. and in Europe. It’s likely the 10 years or more it took for the U.S. to get to where it is will be shrunk considerably in the Asian markets. So within two or three years, the amount of low latency trading happening in the region across listed cash equities, options and futures and other derivative products is definitely set to grow.